Preparing for CSRD - Understanding the genesis of Double Materiality

As of January 1, 2024, the extra-financial performance statement of European companies is evolving and becoming more ambitious, moving from the NFRD to the CSRD (Corporate Sustainability Reporting Directive).

The main objective of the CSRD is toHarmonize corporate sustainability reporting And ofimprove the availability and quality of published ESG data.

The latest publication from the AMF (Autorité des Marches Financiers) confirms that the CSRD involves”strengthening and standardizing reporting obligations”. And specify that”businesses will have to publish detailed information about their risks, opportunities and material impacts in connection with social, environmental and governance issues, according to a principle of “double materiality” ””.

To support you in the preparation of the CSRD, and because “Double Materiality” is the cornerstone of this new sustainability reporting guideline, we offer you a series of articles to understand, dissect, and then put into practice this principle of “Double Materiality”.

1. Understanding the genesis of the Double of Materiality
2. Financial materiality - Detecting climate-related risks, dependencies and opportunities
3. Impact materiality - Identify and assess the company's external impacts (coming soon)
4. Beyond the regulatory - Why should all companies do a double materiality analysis? (coming soon)
5. Our practical guide to setting up a double materiality matrix

And because at Ditto we like to put concepts into context, today we invite you to understand the genesis of this concept of Double Materiality.

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1. What is a material impact?

While double materiality is at the forefront with CSRD, the concept of materiality is not new since it is one of the foundations of financial reporting.

According to the definition of the US GAAP (Generally Accepted Accounting Principles), “materiality is an accounting principle under which all items that are reasonably likely to affect the decision-making of investors should be recorded or detailed in a company's financial statements”.

This means that any information that helps investors and shareholders understand the potential impact of a factor on a company's financial performance can be considered important, and therefore material.

The concept of materiality therefore reflects a perspective focused on the company and its financial value, and in particular on the potential loss of value that “material” issues, in particular environmental, social or governance (ESG) risks, could cause investors to suffer.

Indeed, in recent years, the financial sector has become a key arena for climate action. This interest of finance in climate issues has a twofold origin:

• Investment and financing activities in connection with climate goals (energy transition, etc.), also called impact investing. ‍
• ESG risk management, for example climate-related risks, such as extreme weather events or rising carbon prices.

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2. Double materiality: a response to the need for financial transparency

However, materiality, focused solely on the financial performance of companies, was no longer adapted to reflect the reality of the impacts of businesses on their ecosystem.

To complete this vision, financial players were interested in the concept of external materiality, that is, taking into account the impacts that organizations have on the environment, society and human rights.

The emergence of the concept of external materiality has gone hand in hand with a reinforced, but unfortunately unmet, requirement for the granularity, quality and usability of data on the extra-financial performance of companies.

Indeed, without access to reliable and quality data on the impacts of their investments, financial actors often feel unable to make decisions related to the climate or, more generally, the management of ESG risks.

To better understand, here are the main scenarios in which financial actors need sustainability-related data to make decisions:

• Investors have a risk-based approach and therefore want to assess the various ESG risks.
• Investors put in place a specific investment strategy oriented to sustainability out of conviction.
• Investors, especially long-term investors or institutional investors, are rational and see that “CSR” assets are better valued and more stable.

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3. Double materiality: taking into account the impact of organizations on their ecosystem

Thanks to the work of the TCFD, it is now accepted in financial markets that climate-related impacts on a company can be significant and must therefore be disclosed.

The concept of double materiality takes this notion even further: it is not only the impacts related to ESG risks on the company that can be material, but also the impacts of a company on its ecosystem (environment, social and governance).

Dual materiality therefore includes two perspectives of materiality:

‍ Financial materiality

This perspective includes all the risks and opportunities related to sustainable development that are likely to positively or negatively affect the development, performance and position of the company in the short, medium or long term and therefore create or erode its corporate value.

Environmental and social materiality (now called “impact materiality”)

This perspective concerns questions that reflect the significant real or potential impacts on people and the environment of the company's operations and its value chain both upstream and downstream.

Dual materiality is bringing about a paradigm shift. This means recognizing that the responsibility of businesses and financial institutions does not end with their financial performance, and that they must also manage and take responsibility for the real and potential negative impacts of their decisions on people, society and the environment.

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4. Double materiality: a structuring principle of CSRD

The application of this concept took place as early as 2019, with the adoption of the European Union regulation on the disclosure of information relating to sustainable finance, which requires investors to disclose not only the risks for themselves, but also the negative impacts of their investments on the planet and society.

Dual materiality is at the heart of the new European regulation on extra-financial reporting: the CSRD (Corporate Sustainability Reporting Directive), which replaces the NFRD.

It is in the framework of the development of this new European directive that EFRAG, the European association in charge of developing accounting and extra-financial standards for the European Commission, proposed a definition of double materiality distinguishing between financial materiality and impact materiality.

This double materiality is an absolutely essential part of this new extra-financial reporting standard, since it constitutes the new standard for identifying important and priority ESG issues for each organization.